Chapter 5 Interest Rates and the cost of money

Cost of Money and Interest Rates

1. Chapter 5 The Cost of Money Interest Rates

2. Learning Outcomes Describe the cost of money and factors that affect the cost of money. Describe how interest rates are determined. Discuss how government actions and general business activity affect interest rates. Describe how changes in interest rates (returns) affect the values of stocks and bonds and other assets.

3. Money has a price; a cost Lenders/investors demand to be paid a price for their capital Users/borrowers pay a cost for access to capital COST OF MONEY IS MEASURED IN INTEREST RATES Expressed as an annual amount. The Cost of Money

4. What price suppliers of capital demand and what price users of capital are willing to pay Supply and Demand The more money available, the cheaper it is Time; how long will the capital be used Risk associated with getting paid back Inflation Expectations Any changes to these will impact the cost of capital 4 Factors that Affect the Cost of Money

5. Inflation expectations are a major component of the interest rate The higher the expectations for inflation, the higher the interest rate Nominal Rate Rate without inflation Real Rate Rate net of inflation Interest Rates-The Cost of Money

6. Federal Reserve Policy Controls supply of money in the economy Open Market Operations Buy/Sell US Treasury Securities Setting the Discount Rate The rate at which the Treasury loans to banks. Federal deficits International Business (Foreign Trade Balance) Economic Activity Expansion/Contraction/Recession/Inflation Other Factors That Influence Interest Rate Levels

7. The higher the rate of interest, the lower a firm’s profits. Interest rates affect the level of economic activity, and economic activity affects corporate profits. YOU SHOULD ALWAYS BE AWARE OF INTEREST RATES AND THE EXPECTATION FOR INTEREST RATES! Interest Rate Levels and Stock Prices

8. Referred to as the Yield or the Rate or Rate or Return This is the amount that is received by providers of capital. Two components to yield Income (always positive) Capital Gains (may be positive or negative)   The Cost of Money

9. Bond: Stock: Dividend + (Sale Price – Purchase Price) Purchase Price $50 + ($200-$150)   The Cost of Money

10. One year ago, Regina purchased $1,050 worth of Elite Electrician’s common stock for $42 per share. During the year, Regina received two dividend payments, each equal to $0.05 per share. The current market value of the stock is $44 per share. What yield did Regina earn on her investment during the year? Stock Example

11. Yesterday Travis sold 1,000 shares of stock that he owned for $29 per share. Travis purchased the stock one year ago for $28 per share. During the year, Travis received a quarterly dividend equal to $0.10 per share. What return (yield) did Travis earn during the time he owned the stock? Stock Example

12. Holding Period Return. Return received over the holding period. Does not account for Time Value of Money. Average Return. Return Received/Holding Period. Does not account for Time Value of Money. Used deceptively to inflate actual annualized returns. Geometric Return Considers Time Value of Money It is the true annualized rate of return Measures of Return

13. The Value of any asset is the PV of the Expected Cash Flow discounted at an investor’s required rate of return The Cost of Money as a Determinant of Value